The Profitability of Contrarian Stock Pairs Identified Using a Partial Adjustment Model: An Evaluation of Chinese and Australian Stocks

Santosh Mon Abraham

Abstract

This paper studies two contrarian strategy; one based on the Law of One Price (LOP) and another based on the Markov switching strategy. The stock pairs are identified using a new derivation of the partial adjustment model (PAM), cointegration and Markov switching is applied to the pairs. The Markov strategy is more profitable than the LOP strategy. Both are profitable and their portfolios are combined in different proportions in the efficient frontier. The optimal portfolio is calculated. Cointegration implies short-term divergence and long-term convergence, therefore these stocks are inefficient in the short-run, but they are efficient in the long-run, providing support to Wilson and Marasdeh (2007).

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